Although Markowitz's mean–variance portfolio theory has been criticized in the aftermath of the 2008–09 financial crisis, the author believes in its continued relevance to the investment industry. Furthermore, he asserts that Markowitz’s theory is equally consistent with strategic asset allocation and tactical asset allocation theories.
What’s Inside?
The author supports Markowitz's mean–variance portfolio theory and highlights that it is valid even after the 2008–09 financial crisis. He also counters criticisms of the theory, arguing that it is equally consistent with strategic asset allocation and tactical asset allocation theories.
How Is This Article Useful to Practitioners?
Since the financial crisis, many investment professionals have criticized Markowitz’s modern portfolio theory, which is based on the mean–variance portfolio. The main criticisms are that its focus is wholly on diversification and that it does not incorporate the concepts of asset valuation and of expensive and cheap asset classes. The author counters that these concepts are linked with expected return in Markowitz's theory, whereby an investor who believes that an asset is undervalued will expect a higher return from that asset and vice versa.
As a proponent of pursuing diversification in traditional, strategic asset allocation portfolios as a well-balanced approach to portfolio management, the author explains that the purpose is to reduce—not eliminate—relative losses. Elimination would only be possible with lower-return, risk-free asset classes. In addition, the benefits of diversification are always higher in bear markets than in bull markets.
According to the author, tactical asset allocation on a standalone basis relies heavily on the extrapolation of past data to predict future returns. This strategy suffered badly in the recent financial crisis. Similarly, the performance of alternate asset classes was poor during that period.
Abstractor’s Viewpoint
A well-balanced approach to asset allocation in view of risk–return trade-offs, expected valuation, and adequate diversification is critical for investment managers to sustain performance parameters.